Struggling Homeowners Headed Off the Fiscal Cliff

If you’re working with your mortgage lender to modify your loan, hurry. Otherwise, you could be in for a nasty shock in April at tax time.

As the nation edges closer to the “fiscal cliff,” it’s not just millionaires and the middle class who might be looking at higher taxes. Struggling homeowners are also headed toward their own tax cliff, with potentially dire impacts for the housing market’s recovery and for lower-income homeowners in particular.

Unless Congress acts otherwise, mortgage principal reductions will become taxable “income” after December—even though no cash changes hands when a mortgage is forgiven and almost no one seeking a loan modification is in a position to pay hefty taxes (if they had cash, they likely wouldn’t seek a modification in the first place). A relatively small principal reduction of $20,000, for example, would mean $3,000 in taxes at a 15 percent rate—potentially insurmountable for a homeowner facing foreclosure after, say, a job loss.

For desperate homeowners, taxing principal reductions would essentially take loan modifications off the table—and at a time when the market is recovering but still vulnerable. When Congress finally cuts a deal on the taxes set to expire this year, it shouldn’t overlook these homeowners.

The particular provision in question is the Mortgage Debt Relief Act of 2007, passed in response to the deepening foreclosure crisis. As millions of borrowers plunged into default, and policymakers sought to keep people in their homes, Congress changed the tax law to temporarily exclude principal reductions from “income” normally taxable by the IRS.

But with housing not yet “normal,” there’s still strong reason to encourage modifications, especially with principal reduction.

For one thing, homeowners still need help. Consumer credit reporting agency TransUnion reports the national mortgage delinquency rate for loans 60 days past due was 5.4 percent in the third quarter of 2012. While declining, it’s still above what TransUnion calls the “more ‘normal’ conditions of a delinquency rate in the 1-2 percent range.”

There are also still deep pockets of distress. According to the Mortgage Bankers Association, 13 percent of mortgages in Florida are in foreclosure, as well as 8.9 percent of mortgages in New Jersey and 6.8 percent of mortgages in Illinois.

Another reason to encourage modifications is that lenders are finally doing them.

After a sluggish start, lenders have modified more than 5.8 million mortgages since 2007, says HOPE NOW, including nearly 1.1 million mortgages under the Home Affordable Modification Program (HAMP), the federal government’s leading mortgage modification effort. As of September 2012, more than 132,000 “trial” HAMP modifications were in progress.The majority of these modifications involve principal reduction, and under HAMP modifications alone, homeowners have saved $15.6 billion in mortgage payments to date.

Moreover, the nation’s five largest mortgage servicers have yet to spend down the money committed to mortgage relief under a $25 billion settlement this year with the federal government and state attorneys general over “robo-signing.” Under this deal, at least $10 billion is to go toward principal reduction. After the months it took for this settlement, it would be a mistake to allow any policy changes that could discourage every last dollar of this money from going to homeowners.

Third, loan modification might be the best way to preserve the wealth of lower-income and minority communities disproportionately damaged by the housing crisis. In Chicago, for instance, the Woodstock Institute found that nearly half the homes in minority communities were underwater or close to it, versus just 16.7 percent in predominantly white neighborhoods.

Data suggest that minority borrowers are especially benefiting from loan modifications. For example, researchers at the University of Wisconsin-Madison and the Federal Reserve Bank of San Francisco concluded that minorities were somewhat more likely to receive loan modifications than whites. Among delinquent borrowers who took out loans in 2005—the height of the subprime lending boom—11 percent of African-American borrowers got modifications, versus 5 percent of whites. And while evidence finds minority homeowners are more likely to end up in foreclosure, the study found that modifications virtually eliminated that elevated risk.

For lower-income borrowers, loan modification is particularly important because housing makes up a larger share of household wealth. In 2010, says the Federal Reserve, housing accounted for more than a third to one half of the total assets held by people in the bottom 40 percent of households by income, versus just one-fifth of the total assets held by families in the top 10 percent. Given the outsized importance of housing to these families, modification might be the best way to save what wealth they have. Levying taxes on loan modifications, however, could tip these same families into foreclosure.

Extending the Mortgage Debt Relief Act currently has bipartisan support, but because it wasn’t part of the original Bush-era tax cuts, it could just get lost in the shuffle. This would be tragic for struggling homeowners who might get the burden of a tax bill instead of much-needed mortgage relief.